All Economics Courses for A-Level and High School Students, and most foundation and introductory courses at university, will require you to learn about Aggregate Demand. A very basic introduction to AD is below.
Aggregate Demand, in one classic formulation, is the total amount that all the sectors of the economy willingly spend in a given period. It combines all the demand in all markets of an economy. There is a simple formulation in A-level of the elements of AD: C+I+G+X-M. This is a combination which reflects Consumption, Investment, Government net spending, and net exports.
You should recall that in the macroeconomic world, multiple things act upon each other at all times. This means that you cannot isolate a cause or effect of changes to the exclusion of everything else, as you can in microeconomics. There are certain things we can say, however.
Most movements along the AD curve are caused by changes in the price level. Inflation changes expectations, spending, and the income and substitution effects. So a fall in the price level will result in more AD, a rise in the price level will restrict AD.
At all times, the largest part of AD is consumption—about 65-70% of the whole as a rule of thumb—so inflation, whether driven by a push from costs, a pull from increasing spending, or a fall in the value of money, will affect C which will affect AD. This is the principal reason why the AD curve is downward sloping; at lower price levels, people will spend their cash. Investment is also around 10-15% of consumption at most times, and with lower inflation, there is a greater return on investment, so one would expect to see more money chasing opportunities.
On the other hand, an economy can also experiences shifts in the AD curve to the left or right.
· Shifts in household wealth, or the perception of household wealth, will change spending and move AD to the left or right. This is what a wealth effect involves.
· Very closely related to this, shifts in confidence or expectations on the parts of businesses and consumers will cause AD to shift. If people feel good about the future, they will spend more, invest more, and consume more. Though of course this may be tempered by a greater purchase of imports, travel abroad (an import because people are giving money to foreigners) or Government taxation on incomes and profits.
· Government policy will affect the AD curve. Remember, Government has three broad sets of policy tools; fiscal policy, which relates to the taxation and spending decisions it makes in its budget, monetary policy, which is usually controlled by the Treasury and Central Bank and which related to the basic interest rate, the exchange rate, and the amount of cash, and supply side policy. This last policy is really about the regulations and activities by which government affects consumer behaviour and industry.
Remember, since this is macroeconomics, we make these distinctions but sometimes policy tools overlap. For instance, a tax or subsidy aimed particularly at one group of consumers or suppliers will be both a supply side and fiscal policy. Similarly, an exchange rate policy geared towards the promotion or maintenance of national industry by the manipulation of the currency is a monetary policy which will have supply side and fiscal effects. Students answering questions on the point will generally have to identify the primary cause and effect (eg fiscal policy and consumer behaviour) and you will not be expected in short answer questions to go on about any complications. In long answer questions, you can gain points by elaborating, so long as you do not confuse your main point.
You may be curious about, and seek a fuller explanation for, why the AD curve slopes downwards. The reason is the combination of the wealth effect, the international trade effect, and the interest rate effect. The wealth effect occurs because people have more disposable income when prices are low (usually but not always—see below), so they spend more. The international trade effect occurs because a low price level makes exports competitive against the products of countries with the same or higher price levels, and this boosts the ‘x’ part of the C+I+G+X-M formula. The interest rate effect is that, at low price levels, interest rates tend to be low, which leads to more investment and more credit-fuelled spending, as well as a lower benefit to saving than in other times.
There are circumstances where lower prices don’t connect to rising AD. Deflation in terms of falling prices could be caused by producers and retailers not being able to sell anything, or having overstocked warehouses they have to clear before they can produce things. This will mean people hold back from purchases, because they have lost their job, or because money is tight. This in turn will mean less investment.
Also, if consumers start to believe things will be even cheaper in the future than they are now, they might hold off from buying anything. By the same token, falling prices mean that debt is relatively greater as a burden, because it represents money that could be much better used. Debt burdens rise when prices are falling.
Finally, rising productivity caused by new technology or cheap energy could mean that wages and profits rise faster than prices, which could in turn mean more AD despite a lower price level. This is something that happens only a few times a century and which is a sweet moment to live through—though people seem to respond by buying up so much property, and spending so much on credit, often on imports, that a technology boom is followed by a financial and production crisis. As a general rule, the bigger the boom, the bigger the bust!
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